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The Next Great American Metropolis Is Taking Shape In Texas

As interest rates spiked this month, I've received numerous questions about bond investments. The concern is that as rates rise, the value of existing bonds go down. Some have suggested to me that a 100% stock portfolio is in order as the 30-year bull market in bonds seemingly comes to an end.

A trader works beneath Vale SA signage on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Tuesday, Nov. 29, 2016. Vale SA is resuming dividends as a commodities rebound allows the top iron-ore miner to avoid posting its first year without shareholder payments since a 1997 privatization. Photographer: Michael Nagle/Bloomberg

Before you sell off your bonds, however, let's dig into this issue a bit more. We'll look at why rising rates lower bond values, how to determine a bond fund's sensitivity to rising rates, and how long-term investors should react to a rising rate environment.

Interest Rates And Bond Values

As interest rates rise, the value of existing bonds go down. That's counterintuitive for some. A simple example will clarify the situation.

Imagine you invest $10,000 in a 10-year bond that pays 2%. Now imagine rates on 10-year bonds jump to 3%, and you want to sell your investment. Could you sell your bond at its $10,000 face value? Absolutely not. Why would an investor pay face value for your bond when he could invest $10,000 in a new 10-year bond and earn 3%? Instead, the bond's value will go down to offset its lower interest rate.

One could of course choose not to sell the bond, but the loss is just as real. If an investor holds on to the bond, he earns interest at a below market rate of 2% in our example. It may not feel like a loss, but it's a loss.

In these circumstances, an investor wants the return of her money as quickly as possible so that it can be reinvested at the higher 3% rate. At first glance it may appear she needs to wait ten years when the bond matures. In reality, however, she'll start to see the return of a small portion of the money with the first interest payment.

These interest payments can be reinvested immediately. And that brings us to a concept called duration.